Faced with these higher prices, the consumer-laborers will demand higher wages from their employers, shifting the SRAS leftward, ceteris paribus, and raising the price level. B. Monetarists believe that (1) velocity changes in a predictable way; (2) aggregate demand depends on the money supply and velocity; (3) the SRAS is upward sloping; and (4) the economy is self-regulating. We could have a 10 percent real interest rate and a 5 percent expected inflation rate, or a 9 percent real interest rate and a 6 percent expected inflation rate, or a 4 percent real interest rate and an 11 percent expected inflation rate, and so on. What are the assumptions and predictions of the simple quantity theory of money? Monetarists believe that changes in the money supply are both a necessary and sufficient condition to cause inflation. Suppose the money supply rises. With respect to the interest rate, (a) what is the liquidity effect? A. Monetarists believe that the velocity of money is highly stable. The new short-run equilibrium is established at point 2, where AD2 intersects SRAS1.There is a fall in the price level from P1 to P2 and also a fall in the GDP from QN to Q1. The economy is self regulating (prices and wages are flexible) Monetarists believe: the … As a result, any changes in the money supply that cause the aggregate demand curve to shift rightward or leftward will change only the price level but not Real GDP. Some monetarists believe that the velocity’s unexpected behaviour in recent years has to do with problems of definition or measurement. The first quarter could be described as an increase in the demand to hold money by the public. The AD Curve in the Simple Quantity Theory of Money—MV stands for total expenditures in this theory. Therefore, the aggregate supply curve is vertical at some level of Real GDP. D) all of … According to Friedman, changes in government expenditures and taxes have no visible effect on the economy, and hence the multiplier is non-existent. D. Monetarists believe that output can be at less than full employment output in the short run. Suppose the money supply increases, boosting aggregate demand and raising the prices that consumer-laborers must pay for goods and services, while the short-run aggregate supply curve remains unchanged. c. the SRAS curve is upward sloping. Graphically show the short run and long run effects of a decrease in the money supply or velocity. Further, interest rates might rise. C) changes in government spending and taxes cause the aggregate demand curve to shift. Velocity Changes in a Predictable Way—Monetarists do not hold velocity to be constant. Explain what happens to the price level when the money supply increases. Monetarists believe there is a strong relationship between changes in the money supply and inflation. In the simple quantity theory of money, changes in the money supply affect the price level but not Real GDP. 18. Monetarists believe that the velocity of money is highly stable. Price ceilings lead to a shortage in the market. The expectations effect is the change in the interest rate due to a change in expectations. In recent years, economists have argued about the true value of the real interest rate at any one time and over time. "One-shot inflation may be a demand-side (of the economy) or a supply-side phenomenon, but continued inflation is likely to be a demand-side phenomenon. B) a change in the quantity of money causes the aggregate demand curve to shift. This preview shows page 9 - 13 out of 29 pages. A) the aggregate demand curve is downward-sloping. 4. Monetarists also believe output Y is fixed. In the above figure, an increase in the money supply or velocity will shift the AD curve rightward from AD1 to AD2, causing the price level to rise from P1 to P2 while Real GDP rises from Q1 to Q2 in the short run. The economy is in a recessionary gap at point 2. d. Monetarists believe that … Usually, the demand for loanable funds increases by more than the supply of loanable funds, so that the interest rate rises (Exhibit 7c). When the money supply increases, the AD curve shifts rightward and the price level rises. Explain your answer. Can anything offset the increase in the money supply so that Real GDP does not rise? What does the real interest rate equal, given the following: (a) Nominal interest rate = 8 percent; expected inflation rate = 2 percent; (b) Nominal interest rate = 4 percent; expected inflation rate = -4 percent; (c) Nominal interest rate = 4 percent; expected inflation rate = 1 percent. Hence, when the price-level increases, the price-level effect predicts that interest rates will rise. To this end, it increases the money supply. The price level falls further to P3 and the Real GDP is back at QN position. This is also the sum of the expenditures of the four sectors of the economy, or, Dropping the Assumptions that V and Q are Constant. In the short run, changes in the money supply or velocity will affect the price level, real GDP, and the unemployment rate. Scholars, including monetarists, know that quarter- to-quarter changes in velocity are unpredictable. Of course it is a matter of some debate as to whether the velocity of money is stable. Aggregate Demand Depends … Suppose the objective of the Fed is to increase Real GDP. The problem is that it is difficult, if not impossible, to observe the expected inflation rate. d. a and c e. a, b and c. ... Monetarists believe all inflations are one-shot inflations and Keynesians believe all inflations are continued inflations. Disagree. The new long-run equilibrium is now established at point 3 where AD2 curve intersects SRAS2. In the simple quantity theory of money, the velocity of money and the Real GDP are assumed to be constant. Borrowers increase their borrowing in anticipation of higher inflation and lenders lower their lending. 2. B) Monetarists believe that the velocity of money is predictable. As jobs are scarce, in the next wage negotiation round, workers receive lower wages, shifting the SRAS curve right, as in panel (b). For example, if inflation is 10 percent and interest rates are 11 percent, the real interest rate is only one percent. In the long run, labor market shortages will increase the wage rate, which will shift the AS curve leftward from AS1 to AS2, causing the price level to rise again from P2 to P3 while Real GDP will return to its original level. 1. Neo-Keynesians are less confident and argue that either contention is an exaggeration. Changes in expected inflation affect both the supply and demand for loanable funds. In the end, the effect on the interest rate due to a rise in the price level remains. Explain what happens to Real GDP when the money supply increases. But numerous combinations of real interest rates and expected inflation rates will give us a 15 percent nominal interest rate. Things will not change. Explain your answer. In monetarism, how will each of the following affect the price level in the short run? Graphically show how a change in the money supply leads to a change in the price level, but not to a change in real GDP. Fiscal policy is not effective unless there is a change in money supply. From the producers' perspective, the inflation was caused by higher wage demands. When Real GDP rises, peoples' wealth is greater and they supply more loanable funds (causing interest rates to fall), but profitable business opportunities abound and firms demand more loanable funds (causing interest rates to rise). A) the aggregate demand curve is downward-sloping. The AD curve will be affected equally in opposite directions by the two factors and remain where it started. Given that the Nominal interest rate = Real interest rate + Expected inflation rate, it follows that the Real interest rate = Nominal interest rate - Expected inflation rate. Explain your answer. According to monetarism, an increase in the money supply will lead to a rise in Real GDP in the long run. How will things change in the AD-AS framework if a change in the money supply is completely offset by a change in velocity? According to Friedman, changes in government expenditures and taxes have no visible effect on the economy, and hence the multiplier is non-existent. Jennifer received on their savings account over the year? List the changes in the money supply, velocity, and Real GDP that are inflationary. 1. In a country with price controls, inflation is seen in the length of the lines. They do not believe that velocity is constant, nor do they believe output is constant. (a) An increase in velocity will tend to increase the price level. When the money supply increases, the expected inflation rate increases. The assumptions of the simple quantity theory of money are that velocity and output are constant. However, a change in the money supply changes real GDP, the price level, and the expected inflation rate, all of which also affect the interest rate. Explain how to turn the equation of exchange into the simple quantity theory of money. Provide three interpretations for the equation of exchange. Inflation refers to any increase int eh price level. In the above figure, aggregate supply curve shifts leftward from AS1 to AS2, causing the price level to rise from P1 to P2 while Real GDP falls from Q1 to Q2 in the short run. (a) The real interest rate = 8% - 2% = 6%. As shown in Exhibit 4, some factor causes AD to shift to the right in panel (a), creating an inflationary gap and lowering unemployment below the natural unemployment rate. Therefore an increase in the Money Supply will lead to an increase in inflation. Usually, the demand for loanable funds increases by more than the supply of loanable funds, so that when the Real GDP increases, the income effect predicts that interest rates will rise. Monetarists believe that a. velocity changes in a predictable way. b) Monetarists believe that output can be at less than full employment output in the short run. c. the SRAS curve is horizontal. In the simple quantity theory of money (since velocity and output are assumed to be constant), a rise in the money supply will lead to an increase in aggregate demand. The reason is that it is easier to produce continuous increases in aggregate demand that increase the price level than for the economy to undergo continuous supply shocks. The longer the lines, the higher the inflation rate. Money and the supply of loans—The supply of loans rises as the money supply increases and reserves in banks increase. The money supply, the loanable funds market and interest rates. If velocity were to decline, it could counteract the change in M, so that Real GDP does not rise. The simple quantity theory of money equation states that MV = PQ, where Q equals Real GDP. Explain what happens to the supply of loans when the money supply increases. The liquidity effect is the change in the interest rate due to a change in the supply of loanable funds and occurs when the Fed increases reserves in the banking system, therefore increasing the supply of loanable funds. This is illustrated in Exhibit 5. Think of a robotic Fed, no humans to screw it up. Monetarists believe (1) the economy is self-regulating; (2) changes in M and V can affect aggregate demand; and (3) changes in M and V will change P and Real GDP in the short run, but only prices in the long run. On the other hand, a supply shock (such as a crop failure) would shift the SRAS curve to the left, causing an increase in the price level. Graphically show demand-side induced one-shot inflation. When the price level changes, a price-level effect and an expectations effect will occur. In the next round of wage negotiations, workers demand and receive higher wages, shifting the SRAS curve left, as in panel (b). The economy is back in equilibrium, and there is no reason for the price level to increase from this level. To a potential borrower, which would be more important ,the nominal interest rate or the real interest rate? For inflation to continue there would have to be crop failures every year without a reallocation of resources to farming to offset the decrease in supply. Is the rise in the interest rate more likely the result of the income effect or of the expectations effect? A) Monetarists believe that the velocity of money is highly stable. The assumption of stable and predictable V is crucial to the monetarist theory. 35) Monetarists believe that . Explain and diagrammatically represent the difference between one-shot supply-induced inflation and one-shot demand-induced inflation. The policy causes fluctuations in AD. In the real world we do not always observe this strict proportionality, but we do observe a strong direct relationship between money supply growth rates and price level growth rates. The monetarists believe that the direction of causation is from left to right in the equation; that is, as the money supply increases with a constant and predictable V, ... the money supply. 144 Chapter 14 II.MONETARISM —Monetarists believe there is a strong relationship between changes in the money supply and inflation. What does inflation look like in a country that imposes and maintains price ceilings on goods and services? And in fact Keynesians take the view that velocity is actually unstable. Suppose the money supply increased 30 days ago. Explain your answer. One of the consequences of using price ceilings is that non-money rationing devices, such as first-come-first-served will be used. D) all of the above. If the total money supply is initially £1000 and the velocity of circulation is 5. Borrowers will borrow more funds as the interest rate falls, so the demand for loanable funds is downward sloping. Answer: E When the money supply increases, reserves in the banking system increase and banks can make more loans. In such an economy, inflation is felt in the length of the lines of people. Whether the nominal interest rate is higher, lower, or the same today as it was 30 days ago depends on what? When Real GDP rises, corporations will tend to issue more bonds, raising the demand for loanable funds. Changes in the price level depend on the money supply, velocity, and Real GDP. Exhibit 3 explains some of the highlights of monetarism, showing the short run and long run effects of changes in the money supply and velocity. When the money supply increases, the AD curve shifts rightward and, in the short run, Real GDP increases. Explain your answer. Therefore, monetarists continued to argue Friedman’s case that the larger the money supply, the more likely were its effects, going to lead to higher prices rather than higher economic growth. Describe what happens to the expected inflation rate when the money supply increases. ; Slow, steady, unflinching, and predictable growth of the money supply is what Monetarists prescribe. Also, as Real GDP rises, people have more wealth, and increase their lending. The monetarists argue that in the long run V is determined totally independently of the money supply (M). This is called the expectations effect. True Monetarists agree that following a broad money expansion there will be a similar expansion in #NGDP if velocity remains constant . A decrease in the money supply will shift the AD curve leftward from AD1 to AD3, causing the price level to fall from P1 to P3 while Real GDP remains constant. Their position was based on the equation of exchange and the simple quantity theory of money. This of course is a caricature. That is. Do you agree or disagree with this statement? According to the simple quantity of money, what will happen to Real GDP and the price level as the money supply rises? Monetarists also recognise that the demand for money can shift unpredictably in the short run with changing expectations. Here at least there is a measure of agreement between Keynesians and monetarists. In order to cause continued inflation, the Federal Reserve would have to increase the money supply every year, which it is capable of doing. It follows that the. One-shot inflation can originate on either the supply or the demand side. From the perspective of supply side economics, supply siders agree with the Keynesians that macroeconomic instability can result from supply side shocks. An increase in the money supply will lead to a rise in Real GDP in the short run, but then adjustments to labor market. In the simple quantity theory of money, what will lead to an increase in aggregate demand? A.Monetarist Views —There are four positions held by monetarists that we need to understand: 1. Do you agree or disagree with this statement? A one-shot supply-side induced inflation causes the SRAS curve to shift leftward from SRAS1 to SRAS2, causing the price level to increase from P1 to P2. Keynesian and monetarist theories offer different thoughts on what drives economic growth and how to fight recessions. The interest rate will decline (Exhibit 7b). The longer the lines, the higher the inflation rate. In the simple textbook version of monetarism V in MV=PY is often assumed to be constant. One of the consequences of using price controls is that non-money rationing devices will be used - one of which is first-come-first-served, which results in long lines of people waiting to buy goods. Explain your answer. Does the simple quantity theory of money predict well? If aggregate supply decreases, the price level eventually returns to its original level in the long run. If V is stable, it follows from the equation of exchange that there is a direct predictable relationship between money supply and nominal GNP. The quantity equation of exchange is true by definition. Aggregate demand depends on the money supply and velocity 3. In an attempt to offset inflation's effects, interest rates are adjusted for the expected rate of inflation, so that the actual interest rate paid (the nominal interest rate) is equal to the real interest rate plus the expected inflation rate. c. the SRAS curve is upward sloping. What a change in M does to P, however, is a matter of debate. This is unlikely to occur. If velocity is stable, the equation of exchange suggests there is a predictable relationship between … To achieve that direct effect, though, the velocity of money must be predictable.­ In the 1970s velocity increased at a fairly constant rate and it appeared that the quantity theory of money was a good one (see chart). Why or why not? An increase in the money supply or velocity, or a decrease in Real GDP, is inflationary. M is a vertical line (see diagram 3 above). Can you get rid of infaltion with price controls? b. aggregate supply depends on the money supply and velocity. In the above figure, aggregate demand curve shifts rightward from AD1 to AD2, causing the price level to rise from P1 to P2 while Real GDP rises from Q1 to Q2 in the short run. Can the money supply support a GDP level greater than itself? If the Federal Reserve increased the money supply, this would cause an increase in aggregate demand and a one-shot increase in inflation to a higher price level. c) Monetarists believe that the velocity of money is highly stable. If we drop the assumption that V and Q are constant, we obtain a more general theory of price level determination. Since the SRAS curve is vertical in the simple quantity theory, an increase in the money supply (which shifts the AD curve rightward) will increase the price level but will have no effect on Real GDP. If AD was low, increasing the money supply would only increase short-run economic activity. They do not believe that velocity is constant, nor do they believe output is constant. Some monetarists believe that the velocity’s unexpected behaviour in recent years has to do with problems of definition or measurement. Velocity Changes in a Predictable Way—Monetarists do not hold velocity to be constant. When the price level rises, the purchasing power of money falls and the demand for loanable funds rises. 59 out of 61 people found this document helpful. If, the inflation rate was 4 percent over the year, what was the. C) changes in government spending and taxes cause the aggregate demand curve to shift. 4. Despite Keynesian reservations, monetarists made the case for stable and predictable money demand and velocity (Smith 1988:8). Monetarism is a set of views based on the belief that the total amount of money in an economy is the primary determinant of economic growth. 6. Extreme monetarists believe that money supply is exogenous thus wholly determined outside the system, say by independent monetary authority. Starting with long-run equilibrium, use the monetarist model to explain changes in the price level and Real GDP in the short run and long run due to a decline in velocity. As we said, it is equal to the nominal interest rate minus the expected inflation rate. A change in the money supply affects the economy in many ways: changing the supply of loanable funds directly, changing Real GDP and therefore changing the demand for and supply of loanable funds, changing the expected inflation rate, and so on. According to monetarists, changes in velocity can, Suppose the nominal interest rate is 10 percent, the expected inflation rate is 6 percent, and the (actual), inflation rate turns out to be 7 percent. Inflation helps borrowers, who will tend to borrow more when inflation is high. This is called the price-level effect. According to the equation of exchange, MV ≡ PQ, where M stands for the supply of money, V stands for the velocity of money, P stands for the price level and Q stands for GDP. That will increase interest rates. 35) Monetarists believe that . aggregate supply depends on the money supply and velocity. According to the simple quantity theory of money, a change in the money supply will lead to strictly proportional changes in the price level. One interpretation for the equation of exchange is that the money supply multiplied by velocity must equal the price level times Real GDP. Graphically show supply-side induced one-shot inflation. A third interpretation is that total spending (measured by MV) must equal the total sales revenues of business firms (measured by PQ). We know that this 15 percent nominal interest rate is composed of the real interest rate and the expected inflation rate. Traditional monetarists like Milton Friedman, Karl Brunner or Allan Meltzer never claimed that velocity was constant, but rather that the money demand… Explain what turns one-shot inflation into continued inflation. 1. Monetarists believe that future values of GDP can be predicted if the money supply (M) and the velocity of money (V) can be known or predicted. 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